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NEW YORK (Reuters) - The euro hit a six-week low against the dollar on Friday after the European Central Bank said banks will repay less than half the expected amount of loans, while a downgrade of Britain's government bond rating pressured sterling.

The yen dropped against the dollar and euro, with many investors forecasting further weakness as the Bank of Japan looked set to ease monetary policy further to fight deflation.

Banks will repay 61.1 billion euros (53.2 billion pounds) of the second round of the ECB's three-year loans next week, far below the 130 billion euros in repayments expected by the market. The smaller amount suggested many banks are still dependent on the ECB.

"The smaller than expected payback of loans means the ECB's balance sheet will shrink at a slower than expected pace," said Omer Esiner, chief market analyst at Commonwealth Foreign Exchange in Washington. It "further undermined confidence in the state of recovery in the 17-member bloc."

The euro fell as low as $1.3144, its lowest since January 10, retreating from a session high of $1.3244 after the German Ifo survey showed a big jump in business morale in Germany, suggesting a brighter outlook for the euro zone's largest economy.

It was last down slightly at $1.3183, with market players reporting supporting bids around $1.3150-60.

Richard McGuire, senior fixed income strategist at Rabobank, said that Italian banks may have held off repaying the loan due to the uncertainty about the result of the Italian election this weekend.

Analysts are divided over whether centre-left leader Pier Luigi Bersani will be able to form a stable majority capable of pursuing the economic reforms that an uncompetitive Italy needs to exit recession.

Investors were wary about the risk of a fragmented Italian parliament or resurgence by former Prime Minister Silvio Berlusconi, which could hinder the euro zone's third largest economy from fighting its longest recession in 20 years.

A report from the European Commission on Friday that forecast the euro zone economy will contract again in 2013 also weighed on the euro, which fell for a third straight session.

On the week, the euro fell 1.3 percent versus the dollar, declining for the third straight week.

UK DOWNGRADE

Moody's Investors Service late Friday cut the United Kingdom's credit rating to Aa1 from Aaa, citing weakness in the nation's medium-term growth outlook that it now expects to extend for a number of years. The outlook on the credit is stable.

Sterling fell from $1.5247 to $1.5160 after Moody's downgrade and was last at $1.5248, down slightly from the previous day's close of $1.5253.

"It's a pretty big deal. We didn't see a huge reaction in the pound because it's late in the New York session. But you'll see some more aggressive selling when the markets open on Sunday," said Kathy Lien, managing director at BK Asset Management in New York. "So many people were focused on the yen and the euro that not everyone was already short sterling. So this could compound the pain."

Against the yen, the euro rose 0.3 percent to 123.12 yen. The dollar rose 0.3 percent to 93.39 yen, not far from a 33-month high of 94.47 hit last week, but was on pace for a weekly loss of 0.3 percent.

Some market players said the fact U.S. policymakers had not particularly objected to yen weakness, which makes Japan's exports more competitive relative to those of other countries, meant the downtrend could continue.

"We didn't really realize how aggressive the Japanese officials would get, and we also didn't really sense the U.S. condoning it as much as they did," said John Vail, chief global strategist at Nikko Asset Management.

"It could be that they are quite willing to let the yen get to this level. My sense is that the 95-105 yen level is the intended range."

The Australian dollar regained ground after hitting a four-month low of $1.0221 against a broadly stronger U.S. currency on Thursday. It was last up 0.8 percent at $1.0325.